6. Efficient Markets vs. Excess Volatility Professor Robert Shiller: I want to talk today about the efficient markets hypothesis. Let me just first say, last lecture was about insurance and I was telling you about the theory of insurance and how it has evolved over the years and how it has produced some real benefits. Is that better? It says, "Mike volume." I wanted to just tie this in — the advantages of insurance that we have to some big events that occurred and that will, I think, point out the strengths and weaknesses of our institutions. We had a terrible hurricane a couple of years ago in Los Angeles; Hurricane Katrina damaged the city of — I'm sorry did I say Los Angeles? You have to stop me when I say things that are obviously wrong. My mind lapses sometimes — New Orleans — and Los Angeles doesn't have to worry about hurricanes as far as I know, unless there's some major change. In New Orleans there was a Hurricane Katrina; it broke the levies that were surrounding the city and caused the flooding of the city. What saved the people of the city, mostly? I would say it was actually the insurance institutions because the city was heavily damaged but homes were generally insured. There were some conflicts when this huge disaster came. Some people had wind insurance and some people had flood insurance and it became difficult whether this was a wind or a flood problem, because the wind caused the flood. So, if you had only wind insurance are you covered? There was a lot bickering and arguments afterwards but I think it worked out well. There were surveys of customer satisfaction after the event and I think, generally, people were happy with their insurance companies. Of course, there were some that were not, who may have found out that they weren't covered; but on the whole, the experience worked well. The other thing I want to say about the last lecture is that as financial progress moves on, the distinction between insurance and other forms of risk management may get blurred. One very interesting thing that's been happening is that we are starting to see development of another institution called the catastrophe bond, which is another way that people have for protecting themselves against catastrophes and it's not insurance. A catastrophe bond is a bond that the issuer doesn't have to pay off if there's a catastrophe. You could have hurricanes — the City of New Orleans could raise money with catastrophe bonds that they have to pay back if there's no hurricane but they don't have to pay back if there is a hurricane. Or it could be some mixture: they'd pay back part of it if there is a hurricane. That's like insurance, isn't it? But it doesn't operate through an insurance company, it operates through a securities market. A good example of that is a couple of years ago the Government of Mexico issued catastrophe bonds against earthquakes. Mexico City was hit by a terrible earthquake about twenty years ago and it's vulnerable to being hit again. So, what does Mexico do about this? Mexico could wait until there is a hurricane (sic) and hope that there's some international relief effort, but that's not a very good way to proceed. We want to arrange it in advance. What Mexico did was issue cat bonds that have to be repaid in the absence of a hurricane and have a lower repayment if there is — I'm sorry, I'm not on my best form today — earthquake. Mexico City does not have to worry about hurricanes either.